There’s little doubt the Fed will take the plunge next meeting and raise the Federal Funds rate by 25 basis points. Although the recovery has been slow, there’s been substantial improvement since the Great Recession. The S&P 500 has reached record highs, modest GDP growth continues, and the labor market is about fully recovered with a 5.0% unemployment rate nearing the NAIRU. After so long at the zero lower bound, a rate hike would be a positive signal by the Federal Reserve indicating the economy can withstand increased interest rates. And, it’s about damn time! Right?
No! Absolutely not! So what if we’ve seen continued progress in the labor market? To hell with the labor market! We need to consider the other side of the coin. After all, the Fed has a dual mandate: maximum employment and price stability. Yes, there is still slack left in the labor market, which the Fed reiterated in stating it required “some further improvement,” but the reality is that the labor market paints a relatively healthy picture, while the status of inflation is the artistic work of a baboon. Year-over-year PCE inflation is nearly zero, and core inflation has been stuck at 1.3%, 70 basis points below target.
Still, reader, you cite Engen et al. (2015). Monetary policy operates with long and variable lags, which can last 25 to 50 months! This means that the inflationary effects of quantitative easing will take place around 2016, and when the Fed raises rates, that too will take considerable time. This means now is the time to act! Good try, but the Fed’s own SEP projections forecast inflation at only 1.4% by the end of the year. The median projection shows that inflation won’t reach 2% until 2018. If such a scenario takes place, the Fed will have undershot their target for over a decade. We could target the forecast, as Svensson and Woodford argue, considering policy operates with a two-year lag. But even targeting 2% over two years highlights the same issue: projections show inflation won’t reach 2% until 2018. So when Doc comes out of his DeLorean and screams that inflation will get out of control if the Fed doesn’t act soon, don’t pay too much attention. Inflation hawks have little to fear. Right now, most measures of inflation are far below target and inflation expectations tell a similar story. Economists should be more worried about the realistic concern of consistently low inflation and the possibility deflation.
Even if inflation were to rise too high in the next few years (it won’t – see appreciating dollar, falling commodity prices, weak global demand), you shouldn’t be too worried about that either. The Fed is a credible inflation fighter, best exemplified during the Volcker disinflation. In the 1970s, the Fed was able to combat excessively high inflation through sharp increases in interest rates, albeit at the cost of high unemployment. This issue is less costly now since the Fed has far more credibility fighting high inflation. The real problem for central banks is fighting deflation and disinflation. Japan, for example, has struggled to alleviate its deflationary spiral. Of course there are other issues with the BOJ, but this problem is essentially universal. The bottom line is a central bank can effectively decrease inflation if needed, but cannot effectively generate it.
This problem is escalated at the zero lower bound. As Brainard notes, it's easier now to raise rates, signal a faster path, and do all the things associated with tightening policy than it is to add more accommodation in light of “historically low” rates. Evans et al. (2015) argues, “Near the zero lower bound, monetary policy tools are strongly asymmetric and can deal with” higher inflation much more easily than excessively weak inflation caused by a premature rate hike. Simply put: there are asymmetric risks at the ZLB. It’s just not worth moving early in light of weak inflationary fundamentals. To preserve credibility, the Fed must wait until the data supports a rate increase and not a moment sooner. There is no inflation, but there are real risks. So for God’s sake: wait.
